Notes From Underground: A Take On Mario Draghi in Two Parts

Part I: Mario Draghi, the master of obfuscation was at his best Thursday as he dodged MULTIPLE questions about the recent STRENGTH in the euro. Journalists were very well prepared and even threw back Draghi’s previous responses about how a 10 percent currency appreciation would lower inflation measures by 0.5 percent. But Draghi met each question with a, “Yes, we discussed it as some members of the ECB Board were concerned about the EURO and its impact on exports and import prices.”

President Draghi did say the ECB forecasts were based on a 1.18 euro/dollar exchange rate. While this issue was being discussed someone pointed out that the EURO was trading over 1.20 but Mario just laughed that off as insignificant. I OFFER THIS: In looking at the EURO chart, the 1.2042 cash level is important for that was the low price made the week of Draghi’s WHATEVER IT TAKES SPEECH in July 2012. The speech was directed at the existential crisis facing the EU and a European sovereign bond market in crisis as global investors were questioning whether the PIIGS (Portugal, Ireland, Italy, Greece and Spain) were going to be solvent.

When Draghi basically guaranteed the sovereign debt of the PIIGS the EURO currency ended its selloff and rallied to 1.40 by May 2014. The euro was able to stage a rally because the U.S. Fed was still in full QE mode and the ECB had not embarked upon such a program. While the ECB did invoke its Outright Monetary Transaction (OMT) program it provided little liquidity. The ECB QE program did not begin until March 9, 2015. Once the FOMC began its TAPERING — reducing the purchases — the U.S. dollar staged a three-year rally versus the EURO and other G-7 currencies.

Thursday, the EURO cash high was 1.2059, testing the July 2012 low. If the EURO can close above this level — and close above that week’s high of 1.2390 — it will be an important indication of significant dollar weakness. I’m just providing perspective in this time of great market uncertainty. To add a little more perspective,I looked at the EUR/YEN cross of that same week in July 2012 and it revealed that the euro/yen cross put in a 17-YEAR LOW ON THAT WEEK. This cross is important because it is representative of the trade competition between Germany and Japan in the high-end auto, electronics, optical and highly engineered machine goods.

Both the ECB and BOJ are active liquidity providers through massive QE programs, which sets up a confrontation between the EU and Japan on trade issues. Today the EURO/YEN cross CLOSED at 130.41 and the 200-WEEK MOVING AVERAGE is 130.70. Many traders believe that President Mario Draghi revealed that the October ECB meeting will result in the recalibration of the QE program (h/t Peter Boockvar on this call two weeks ago), but Draghi warned that if inflation fails to meet the ECB mandate the European central bank stands ready to remain with negative interest rates for longer and it “stands ready to increase PURCHASES if necessary.” Draghi also added that global factors are a risk to the ECB mandate because of foreign exchange matters. Follow the magician’s hands.

Part 2: Calibration … This is the word that supposedly caused the strong rally in the EURO as the President Draghi discussed the euro currency but would not reveal any hint to the beginning of tapering. But Draghi did mention recalibration, which some commentators took to mean that a balance sheet shrinkage would be announced at the ECB’s October meeting. As i think about RECALIBRATION I offer up this hypothesis: The current QE program of the ECB is 60 billion euros a month but the EURO has rallied 10 percent against the U.S. dollar. Therefore if the ECB can recalibrate to 50 billion euros without any real change in the dollar value that can pass as a recalibration. We will see what happens come the October meeting. Now it is up to market participants to determine what the ECB means by recalibration.

Buried within Barron’s “Up and Down Wall Street” column by Randall Forsyth is an interesting reference to research team at Wells Fargo Securities led by John Silvia. The basis of the research relates to the importance of the yield curve: “Looking back over six decades, the Wells Fargo team found that the tipping point came when the fed-funds rate exceeded the 10-year Treasury yield’s cyclical low. This has predicted every recession since 1955, with an average lead time of 17 months-producing a significantly earlier warning signal than waiting for the yield curve actually to invert. What about the current cycle? The 10-year Treasury’s low yield was 1.36%, touched on July 5, 2016. An increase in the fed funds rate to 1.5% … at the December FOMC meeting, would trigger the recession early warning signal. Specifically, their research puts a 69.2% probability of a downturn within 17 months after that.” This is something I have to think about but the 17-month period is a long time and my work on just a simple inversion has indicated a negative stock market reaction within four to eight months.

I will pay attention as this indicator may set up well with the 73 basis point support on the 2/10 yield curve that has held for the last few years. Also, while the research goes back to 1955, the crop of massive QE programs from the world’s central banks certainly make this time different. In addition, the current period of free flows of global capital during the time of BOJ, ECB and SNB means that all capital is fungible resulting in effects we have never experienced. But this is an important piece of research that we should all think about.

***One last note: President Emmanuel Macron of France visited Athens last week and proclaimed to the Greeks “… the IMF had no place in EU affairs.” This was in relation to the fact that Macron believed that in dealing with the Greek debt crisis there should have been more debt restructuring rather than continued calls for austerity as the Greek people “…. have paid a very high cost.” Macron forgets that without IMF support the Germans would not have provided capital for the bailout. President Macron wants more solidarity in all things financial for the EU but this means that ECB President Draghi will push for more QE in order to build the massive balance sheet, which will provide the impetus for the EUROZONE BOND. The EU’S largest debtors are in support of the EUROBOND but the Germans continue to resist the idea. Macron and Draghi need Chancellor Merkel to have a decisive election victory.

16 Responses to “Notes From Underground: A Take On Mario Draghi in Two Parts”

We remember Alan Greenspan’s conundrum, where long term rates remained low and declining despite the Fed’s raising short term rates. The almost unmentioned conundrum facing us today is the ineluctable decline in the dollar since the beginning of the year, with new lows for this move set on Friday. Despite active QE programs by the BOJ, ECB not to mention the Swiss and others on smaller scales, while US rates have been raised and QT promised, the dollar defies the expected gravitational pulls. The US economy certainly isn’t underperforming Europe or Japan.

Could it have anything to do with a real estate man running the country, with a view that debt is good ( paraphrasing Michael Douglas’ Gordon Gekko) and with a $20 trillion national debt that may be expanded to levels that make the reserve currency squishy? There isn’t enough theorizing out there to answer a terribly important question.

Asherz–almost certainly a result of the ever increasing debt pile on the books of all levels of government combined with the recent increase in private sector debt–the reserve currency is a burden of responsibility –are we up to the challenge? It appears doubtful

Pierre–don’t know what would prompt the Fed to worry but I beleive the FED will announce the commencement of QT at the upcoming meeting because the weak Dollar does mean they have room to move and as Lael Brainard said in June the impact of QT on the Dollar is not as great as the Fed raising the fed Funds rate

With guidance from world-class FX technician Jamie Saettele, it was an easy technical and sentiment call to be bearish EURUSD to start the year like I previously posted in here. The difficult question now is whether EURUSD is a reaction rally or a trend change. My first line in the sand is the zone of resistance from 128-130. My base case was a 12-24 month reaction rally toward 128, but I have nagging doubts now because of the impulsive nature of this move, and impulsive currency moves have a knack for establishing trends which ultimately don’t really reverse until a Fibonacci 78.6% retracement over a multi-year period. That could setup 140 instead of 128, a double top with May 2014, then reverse down to parity & below subsequently, for the inevitable EU sovereign debt crisis (preceding the inevitable US sovereign debt crisis). Not cheerful.

This EURUSD move from 1.0341 to 1.2094 was a 17% rise, so I don’t understand why Mr Draghi states, “currency appreciation would lower inflation measures by 0.5 percent”? I get it that Europe trades mostly within Europe, but Eurozone trade with China and US is also significant so Draghi’s statement seems out of proportion to the big FX move.

Why didn’t Mr Draghi use a deflationary spin on the EURUSD spike as an opportunity to both jawbone the Euro lower and justify his dovish ECB policies? Has he suddenly morphed into a hawk? Is he being blackmailed by Germans? Or is he just waiting two weeks until after the German election to fly free like a dove? Speculative Euro COT bulls are the most extreme in years, interestingly, as that usually portends a big haircut eventually.

Three thoughts. First of all your take on that recession indicator 17-month forward view is very relevant on both current QE influence distortions and more so how do you trade that? Your 4-8 month indication should be ample for meaningful position management.

Secondly, the short-term rate differentials have NEVER been the primary driver of currency trends… more so a consequence. If they were, how could EUR/USD possibly have rallied this far on a negative 75 basis point euro yield spread? Inward investment sentiment and reality are always far more important, with US economic expectations way overblown into the top of this year and Euro-zone concerns also way too dismal.

And based on Trump’s ‘deal’ with the Dems last Wednesday (more so a pure capitulation) it would not be surprising to see EUR/USD above 1.2000 get to at least 1.2500 or even 1.3000. Likewise for a US Dollar Index that just violated a 2.5 year low at 91.91 sinking first to 90-89, yet possibly getting to 85 overall. Anyone who doubts that can happen to an already ‘oversold’ US dollar should look at how it rallied out of late 2014 into March 2015.

This guy’s strength as a negotiator is significantly overrated, as opposed to his promotional skills. There is quite a bit more on the tech trend view and Trump’s serial failures in the http://www.rohr-blog.com “WEEKEND: Truculent Trump Tribulations” post. That includes links out to vintage perspective on how Trump was always going to be a wrecking ball for the GOP, and background on his more so promoting himself as a great negotiator rather than actually being one.

Also, on the Macron-IMF front, what ever happened to that IMF phony support for the next round of Greek bailout funding?

While the Germans are still saying they aren’t going to provide any more funds unless the IMF continues to contribute, wasn’t the IMF rightfully demanding much more meaningful Greek debt relief (to which the Germans have pathological resistance) prior to actually funding their participation?

Either everyone is content to ‘kick the can’ once again until after the German election, the Germans have dropped their demand (unlikely), or the IMF has agreed to move forward in spite of no further debt relief.

The latter is far more problematic under the new US administration (versus Obama complicity.) And many Congressional Republicans are also calling for a halt to the IMF breaking its own ‘sustainable debt’ protocol (ignored in a major way in the earlier Greek funding) as the price for further, typically major, US funding of the IMF.